Friday, February 25, 2011

For those who think I criticize Ben Bernanke too much in this blog, read this article.

Does the Fed Chair ever buy gas, shop for groceries, or check commodity prices in the newspaper?

I have been warning about inflation in my newsletter and this blog for years. Well, it's here and it's only to get seriously worse, especially for people on a fixed income (like retirees) and investors of all types.

Do a news search for "inflation" and you will see virtually the entire world warning about what's coming.

On the inflation front, we have recently seen increases in some highly visible prices, notably for gasoline. Indeed, prices of many industrial and agricultural commodities have risen lately, largely as a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply. Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable. Over the 12 months ending in December, prices for all the goods and services consumed by households (as measured by the price index for personal consumption expenditures) increased by only 1.2 percent, down from 2.4 percent over the prior 12 months. To assess underlying trends in inflation, economists also follow several alternative measures of inflation; one such measure is so-called core inflation, which excludes the more volatile food and energy components and therefore can be a better predictor of where overall inflation is headed. Core inflation was only 0.7 percent in 2010, compared with around 2-1/2 percent in 2007, the year before the recession began. Wage growth has slowed as well, with average hourly earnings increasing only 1.7 percent last year. These downward trends in wage and price inflation are not surprising, given the substantial slack in the economy.

So, after we factor out precisely the two items that are rising the fastest in price, food and energy, the two essential items people buy and use everyday and the foundation of the U.S. economy, prices are stable.

(This would be like someone saying "Except for the fact that my wife sleeps with the mailman, her boss, and the next door neighbor she's completely faithful to me and our marriage."

And, of course, "longer term inflation expectations have remained stable."

This is very true since the current mortgage underwriting process is very tight.

But what this article does not say is WHY would anyone want to buy real estate with all cash. While you can certainly get a small discount paying all cash for a property, the notion of having an LTV ratio of ZERO on a piece of property is not just financially imprudent but sometimes dangerous.

First, the best reason to invest in real estate is leverage. Other investments will provide you with greater cash flows, liquidity, and less active management. Real estate leverage is the sweet spot of investing. Have you ever heard the old expression that most millionaires have made their money in real estate? Leverage is one of the prime reasons why. Paying cash means no leverage. The idea of paying cash and then refinancing later has merit but think of it this way. If you can't get purchase money financing on good terms, what makes you think you can get it after you purchase?

Second, having so much cash tied up in a single property is dangerous. It's a liability target in case you ever get sued. The market risk of putting lots of your financial eggs in one basic is inherently risky. It's hard to diversify when most of your liquid assets get put into highly illiquid real estate equity.

Third, and most importantly, I don't believe we are at a market bottom anytime soon. Real estate prices are continuing to fall in Seattle, for example, where, incredibly, one-third of all homes are now underwater.

33%. That's massive in a place with a thriving economy like the Pacific Northwest.

And the trend is towards future price declines. So why buy now? To be blunt, isn't the tight mortgage underwriting telling investors something about the perception of market risk? I would not be writing 30-year mortgage paper at 5% when the risk of high inflation is in the air and the value of any real estate equity not so great at the moment.

Tuesday, February 1, 2011

I am not a fan of buy and hold (or buy-and-hold) investment strategies of any kind. They are unremarkably average in every way being the most passive approach one can take towards equity purchases in either the stock market or in real estate.

But this blog site offers some excellent advice on the approach. I want to thank Dave of Portland for sending it to me.

I think the advice the author's give in their "Three Rules" near the end of the article is so important to remember, and to be blunt, many real estate investors don't.

But even for those investors remembering the rules, the fundamental weakness of buy-and-hold investing is the necessity to PREDICT the future in order to sell at a profit. Look at the author's three rules. They all involve making current guesses about future costs and market conditions. Very hard to do, even 50% of the time.

Contrast this with a more moderate cycle trader in the real estate market, buying with a short 12-24 month window from open to close. This means far fewer unknown factors about the future since the deal has a short fuse.

Buying long means knowing long. Knowing short in the market is often too difficult enough. Plus betting on market price appreciation over the long term as an investment strategy assumes there will be some in the long run, a bold assumption at that.